…I am in a position of having a lot of capital not invested. I am about 30% invested, 70% in cash. I only want to invest in equities. I don't have the time or desire to focus on Net Nets. I have a long term approach and don't want to buy and sell often. I have a high risk tolerance. I want to only own equities. Ideally, an investor would deploy cash to buy the best companies in times like 2008 when the market crashed and companies were selling off far below intrinsic values. Do you think it makes sense to wait for ‘blood running in the streets’ and times when one could ‘be greedy when others are fearful’ or to just buy wonderful companies at fair or better valuations? I could be a whole lot greedier in market duress if I didn't deploy my 'lump sum' now. What would you say? What would Buffet say? What if you received a sum of money, inheritance. Should you invest when you believe you can receive 15% return on that money with X margin of safety? How much margin of safety? I was buying in August last year when Greek debt was causing selloffs, it's just easier to pull the trigger when the market seems irrational. But if you have a lump sum and then just regular monthly earnings for the next 20 years, should that lump sum wait in the hope of a market crash? Or should it just be deployed and bought BRK, bought WAT, bought BDMS, bought your next month's pick until I have about 6 high quality companies and then sit back and read annual reports?

Thanks again,

Tom

You say you have no time or desire to invest in net-nets. That’s fine. If you are not inclined to make those sorts of investments, you should focus on only the highest of high quality companies. And you should focus on the very long-term.

I’ll tell you a secret. There are two ways to almost guarantee satisfactory returns in the stock market. One is to buy the very cheapest stocks around. The other is to buy the very best businesses. Everybody tries to do something in between. They want to pay 13 times earnings for what they think is probably an above average company with some wind at its back for the next few years. Or they want to pay 8 times earnings for a company that – let’s face it – probably isn’t above average and just might be below average. These are the two ways to get yourself in trouble. And yet it’s here that most investors spend all their time and analysis. Trying to tell the difference between what stock should have a P/E of 8 and what stock should have a P/E of 18.

It’s not easy work. And the payoff is slim.

No. The way to get consistently good results is to adopt one of two programs – and limit yourself to only focusing on your chosen field:

1. Buy companies that are clearly selling for less than their conservatively calculated value to a private owner

2. Buy companies that will earn high returns on capital while growing quickly for many, many, many years to come

Whichever strategy works for you is the one you choose. But don’t try to dabble outside of that.

And don’t fool yourself about what #1 and #2 mean.

For example, I own 6 Japanese net-nets. When I say buy companies that are clearly selling for less than their conservatively calculated value to a private owner – I mean it. Every single one of those 6 Japanese net-nets (and both my American stocks when I bought them) were selling for less than the surplus cash they had. In each case, I essentially paid for the company’s cash and got the operating business for free. And in every case, the operating business had not posted a loss in the last 10 years.

Now, you don’t have to be an expert on valuation to know that a business that has earned money in 10 of the last 10 years is probably worth more than zero. Perhaps a lot more than zero. And if you buy 8 of these businesses – they’ll work out. So that’s what I did. Not all at once. It’s hard finding stocks that cheap – you usually don’t have the good luck of getting 8 at once. But I focused on just those super obvious bargains. I didn’t try to get too fancy thinking I know enough about the prospects for all sorts of different businesses. Basically, I just bought the best companies I could find that were selling for less than their cash.

Okay. But that’s not your style. That’s fine. But you have to bring the same level of focus and selectivity to your investments. Have you read Phil Fisher’s Common Stocks and Uncommon Profits? If you are going to be a buy and hold investor, these are the books to read:

The idea here is that you should – like Warren Buffett and Charlie Munger – see yourself as a business analyst rather than a stock analyst. I know this is an odd point to stress for a value investor. But if you are heading down the path of true buy and hold investing – you must start by totally ignoring a stock’s price. That can’t be part of your process. At the end of your process, you can pass on a stock because it’s too expensive today. But you have to start with the idea that you are trying to find the company you would buy if you had to put 25% of your net worth into something today and couldn’t take out a dime of that money for the next 20 years.

Which company would you buy?

Now, if that company is trading at 40 times earnings today – you can pass. But if you are going to be a buy and hold investor, you shouldn’t start by looking at stocks with a P/E of 14 instead of 40 and hoping you’ll come across a great business. You want to start by looking for a great business and then keeping it in mind for the day when you can get it at a decent price.

That’s got to be your focus. Now, when you really do find a company that is so terrific in its ability to grow year after year after year for a long time – when that happens – you can buy it no matter what is happening with the market. You may take ugly losses for 1 to 3 years or something. But, if you picked a Phil Fisher stock right – you’ll make money in years 4 and 5 and 10.

Now, if you’re the kind of person who will sell during those first 3 years when this stock – along with the rest of the market – was going down, then you shouldn’t buy it. If you can’t take steep drops in the stock market that last a couple years, you really shouldn’t be buying now. Because stocks aren’t so cheap that I can promise you they won’t get a whole lot cheaper. They could easily fall from here and stay down for years. Even a really good company could.

But if you can definitely hold a company through a tough market that lasts a few years – then you can look for a wonderful business to buy and hold at any time. In any market. I found some lovely businesses around the time of the 2000 market peak. They just weren’t big caps, dot coms, etc. They were smaller more mundane businesses. In at least one case – Bio-Reference Labs (BRLI) – I made some money (it seemed like a scary big amount at the time) holding the stock for about 2 years but I would’ve made a whole lot more if I had just held that one stock through till today. And even now BRLI seems a fine stock to keep holding. So, you see I could’ve saved myself a lot of trouble by holding something for more than 10 years. And it wouldn’t have hurt my performance at all. In fact, BRLI has beaten the market by a lot for a very long time. And, yes, the price I paid for BRLI happens to be the most I ever paid for a stock relative to its record earnings. So, I paid a very high price – for a value investor like me – for a stock that promptly went on to return around 20% a year for the next 10 years and is now back at almost the exact same P/E ratio where I first bought it.

I mention this only to reinforce the idea that there is more than one way to make money in the stock market. And it’s best not to get confused about what you are doing. You can pay 16 times earnings for a super high quality company. And you can pay 85% of cash for a net-net. You just don’t want to confuse the two and try to compromise somewhere in between by paying 13 times earnings for what you think may be a moderately high quality company. You are looking for really obvious cases.

As far as whether you should buy when the market is irrational – I have a hard time knowing when the market is irrational. There are exceptions. I knew in early 2009 – and it was easy to buy then. Basically, I just bought the highest quality companies I could at around 10x free cash flow. I knew that 10x free cash flow is less than stocks are generally worth. And I knew that if I bought the very best companies available at that price – the ones I considered safest competitively – it would work out.

But there is no reason why you have to buy during these moments of market duress. In fact, it may just make you feel better. Since it allows you to understand “why” you are getting a bargain – people are panicking. The idea that something can simply be a good value at its current price – somehow that seems more mystical.

In the Bio-Reference Labs example, the market has returned something like 4% to 6% over the last 10 to 15 years. While BRLI has returned 20% to 30%. So, you could have bought at quite a few different times when stocks generally would give you quite poor long-term results and yet this one particular stock could make you rich if only you had the good sense to hold it all that time (as, alas, I did not).

You mention that you have a lump sum. In investing, there is nothing worse than having a lump sum. You asked me if I received an inheritance whether I would put it to work immediately – no, never. But not because of today’s stock prices (which I believe are overvalued in historical terms but fairly valued or even a bit undervalued relative to bonds and cash). I would never put cash to work quickly because that is when I make big mistakes. All of my worst decisions come when I have too much cash. I very rarely make mistakes when I have to sell one thing to buy another. My batting average when I’m about 50% in cash and would like to put some of it to work is not so good. I hit one homerun when I was in that position. But I’ve had a couple stocks on which I got literally zero return – for a lot of time and frustration – and I blame the fact that I had almost half my portfolio in cash when I was researching those investments.

So, I would never put a lump sum to work all at once. I would give myself one year. I wouldn’t buy more than 1 stock every 2 months. I would make it that formal. I’d use rules as rigid as that. Because I’d be very concerned about making a big mistake.

Don’t focus on the market. Focus on yourself. On your own process. See if you get sloppier the faster you pick stocks. I know I do. I would be careful to space out your purchases. You want to “live” with each stock for a while after you’ve started seriously researching it and before you’ve made the actual buy decision.

Read those books I recommended and try to find the very best businesses regardless of price. If you find some wonderful businesses that are too expensive now, that’s fine. It’s good information to have. Because prices change a lot faster than businesses.

Finally, if you haven’t been invested in a lot of stocks for a while, it may take you longer – or at least it should take you longer – to fill a portfolio. It is relatively easy for someone like me – intellectually at least – to fill a portfolio in the midst of a market crash because I know exactly what companies I’d like to own but have never been able to buy because of price. I already have a shopping list.

But if you are committed to a long-term buy and hold type strategy the one thing you always need to keep at the front of your mind is that price isn’t everything. You are very unlikely to cause any sort of catastrophic problem for yourself just by overpaying for the right kind of company. Buying the wrong company is your biggest risk.

Take your time.

But don’t wait for a market crash.

Just wait for an obviously wonderful business selling for the kind of price a normal stock sells for in normal times.

About the author:

Comments

Let's say you've spent a decade analysing and tracking a dozen companies. You know them better than most. You understand and like what management is doing and you've tracked their performance through a number of cycles.

It's a diversified group of businesses because you track only what you consider to be the best of breed within a given industry.

Within that relatively small investing universe, you could conceivably employ a stratgey of buying one or more of them when you're highly confident they're cheap and selling them only when the fundamentals have changed.

Over time, you would end up with a portfolio of 5-10 compenies that you like and know.

I disagree. I would wait for a market crash and invest elsewhere until then. Currently the only asset class that is a bargain is real estate. The problem I have with many investors on GuruFocus is that the only tool they have is a hammer, so everything looks like a nail. They need to think out of the stock-bond box, IMHO.

To be a better business analyst, I suggest adding Poor Charlie's Almanac to build a series of mental models. Also Ben Franklin's writings on compounding would be wonderful.

Bon voyage on bulding that latticework of mental models!

I suggest a combination of both approaches 1. incremental buys at fair prices now and then, and, 2. keep a cash hoard for the six-sigma (starving man in room full of you know what) event downturn. Notice how Bruce Berkowitz keeps piling into cash as the market keeps going up. i.e. never EVER compromise of Margin of Safety. You'll be surprised to find that some of the best businesses trading at crazy multiples are still priced far below their intrinsic value. e.g. 750 million Indians probably still don't brush their teeth twice a day. What if they do?

In 2008 I went to 85% cash and started reinvesting significant amounts in early March 2009 (a couple BRK-a's). What I didn't anticipate was the amount of gov't intervention distorting the market by interfering with the progression of irrational fears and the progression of disintermediation in a liquidity crisis. I rightly expected and deserved a lot more blood in the streets. :-). Future crashes will be range bound due to government interference and the expectation thereof, so the opportunity cost is far to high to hold significant cash positions for any length of time. Might as well be a gold buyer and at least hope to preserve a bit of purchasing power.

So are there any publicly traded companies current accumulating large amounts of distressed real estate, besides the banks? I have a longer term perspective in mind (20-30 yrs) for some assets that will be inherited.

I'm guessing that the banks are not likely to hold their realestate to maximize future returns, instead they are likely to dump as much as possible - as soon as possible - to relieve themselves of what the perceive to be non-core, substandard assets.

Because, cash gives you an option value that is very valuable during bad times. If you held the S&P 500 and then wanted to buy stocks during a stock market crash, you would find that the value you can buy would be quite low (since the S&P 500 would have also fallen in value). In contrast, if you held cash, you would find that you could buy more value with it.

I remember Mohnish Pabri once making the claim--one of his few mistakes--that Berkshire Hathaway shares can be used a cash-like store of value. Well, needless to say, Berkshire shares fell during the financial crisis, precisely when you wanted to deploy that into other shares.

BATBEER: "Within that relatively small investing universe, you could conceivably employ a stratgey of buying one or more of them when you're highly confident they're cheap and selling them only when the fundamentals have changed.

Over time, you would end up with a portfolio of 5-10 compenies that you like and know.

In your opinion, what are the risks of such a strategy ?"

I don't think Geoff responds to message board comments; you are probably better off e-mailing him. I'm not Geoff and nowhere near as good as him but my thoughts on your idea...

The problem with buying the leading companies is that they are rarely ever cheap. So you need to be absolutely sure they are cheap.

I think your strategy is somewhat similar to the strategy of buying the Dow 30, which some consider to contain the best US-listed companies, and holding it; as opposed to someone buying something broader, say the S&P 500, and holding it. The gap between the two isn't that large.

The other problem--this is an inherent flaw with all value investing frameworks--is that you are vulnerable to macro risks. You can own the best companies within a few industries but if those industries are in secular declines, I'm not sure that you would outperform the market, even if you outperform the sector. For instance, if you held the leading auto company, newspaper publisher, and homebuilder--largely uncorrelated with each other--over the last 5 or 10 years, you probably would have still trailed the market.

I think the key is that your decision on what is the best company must differ somewhat from the market consensus OR if everyone agrees on the best company then your purchase price must be much lower. The reason I say this is because there are many quantitative-oriented investors, as well as quasi-passive invstors, who pick off the "best" companies using automatic formulas and consensus stock ratings and the like. Even if they are not value investors and don't do much business analysis, many of the "best" companies pop up on their filters. I don't see how you can beat those guys, who you can think of as the consensus, if you don't differentiate yourself somehow.

>>For instance, if you held the leading auto company, newspaper publisher, and homebuilder--largely uncorrelated with each other--over the last 5 or 10 years, you probably would have still trailed the market.

The best one is not necessarily the current market leader (or a member of the Dow). For example, AFAIK:

- Ryanair is the best airline stock in Europe

- DJCO is the best "newspaper" in the US.

- Leucadia is the best conglomerate and

- Carmart is the best auto company.

I really don't care about beating any index but I believe all of them have beaten any index you care to compare them with. The performance of the stock is not why they top my lists.

@Sivaram: I so love the following quote. I very much find quantitative filters and automatic screens great for starting points. But, at least for me, it's the "peripheral" searches that turn up gems no one else is taking a look at, eg what's already in the Wall Street Journal, Financial Times, or Barron's, and what the pros knew months ago before it was published. I consider sources like these just information everyone else knows or is looking at, AKA consensus.

"I think the key is that your decision on what is the best company must differ somewhat from the market consensus OR if everyone agrees on the best company then your purchase price must be much lower. The reason I say this is because there are many quantitative-oriented investors, as well as quasi-passive invstors, who pick off the "best" companies using automatic formulas and consensus stock ratings and the like. Even if they are not value investors and don't do much business analysis, many of the "best" companies pop up on their filters. I don't see how you can beat those guys, who you can think of as the consensus, if you don't differentiate yourself somehow."

@Batbeer 2: Also love this quote. Always loved DJCO, as its anchored by a professional customer base who uses the info for a specific purpose: for the job they depend on to earn a living. People also don't realize it has quite a bit of a digital business. Also loooooove Leucadia. Hard to value since they usually purchased distressed assets outright. But they are so good at identifying good buys. You almost have to look at asset value and assume what the company would look like if the businesses they purchase pick up any. Love them!

"The best one is not necessarily the current market leader (or a member of the Dow). For example, AFAIK:

- Ryanair is the best airline stock in Europe

- DJCO is the best "newspaper" in the US.

- Leucadia is the best conglomerate and

- Carmax is the best auto company.

I really don't care about beating any index but I believe all of them have beaten any index you care to compare them with. The performance of the stock is not why they top my lists."

How do you differentiate yourself with category 2 companies (i.e. great, leading, companies that will do well for decades)?

My point was that, with these category 2 companies, they show on almost everyone's list (I'm exaggerating a bit). And if you do go off the beaten tracks, then are these still the category 2 companies (i.e. great companies)?

I don't necessarily look for leading companies so to speak. I don't think DJCO is the leader in legal and real estate news and info (that might be ALM). But I don't expect the business to deteriorate much any time soon (that it's localized may give it an advantage over larger competitors who want to steal its market share). And I see much less downside risk than the average newspaper.

My first concern is that the company will at least retain the real/intrinsic value it already has in the long term. So things like continuous product utility, clear customer retainment, assets/competitive advantages that are tough or impossible to replace for competitors, pricing power/revenue growth that keep up with inflation etc. are important to me. I think I saw someone on this site describe it as "staying power."

Sometimes you'll find great, leading companies off the beaten track. FICO, for example, is clearly a leader in its niche. Barely has competition. Can't say how often.

But again, I'm much more concerned with whether this business will be at least as good as it is now in the future. Part of the reason is that those are the type of businesses I'd rather own or manage myself. Secondly, because terminal value in a DCF valuation assumes that the company will retain its current performance forever.

I don't follow these rules to a T, since I'm always learning new things as I go. But in general it seems to be what I gravitate towards more and more. But, I say all this as an opinionated investment novice more than anything.

>> My feeling is that the companies you listed (except Ryanair) resemble more of the first category that Gannon mentioned i.e. companies that sell cheaply.

Yes, I can understand this. My problem with the two "buckets" is that I think 85% of the stocks out there don't belong in either bucket. I also think about 0.1 % of stocks out there belong in both buckets. Those are the ones I look for. I'm a GURP investor (growth at an unreasonable price).

Ryanair still sells at (or near) the liquidation value of the tangible assets. A few months ago it sold for about 60% of liquidation value.

Carmart.... In a decade, revenue has tripled while SG&A went up 50%. The stock-count went down. This is much better than any Dow component.

We could discus each stock (not a bad idea actually) but it's not the point. If (like me) you happen to believe there is such a thing as an NCAV with a bright future, how could you not restrict yourself to a portfolio of these ? I admit, it's a lot of work. When Buffett bought WPO, that was his thesis.

People don't want to believe a cheap stock can be great. That is precisely what creates the opportunity.

I missed out on Conn's. After screening through 50 net-nets (a rare type of stock !) I came across Conn's. I thought it might be a well-managed retailer with a lot of long-term potential. It was obviously cheap. As it turns out I was right. At the time I wasn't sure so I dumped it. Like with Ryanair and Carmart, people confuse the company with the product. The product isn't sexy so the stock can't be.

Just to calrify: I don't think negatively of Barron's, WSJ, Financial Times etc. They give me a lot of info I would not have otherwise and keep me up to date on what's going on in the world of business or finance. And they give a lot of great insight and source matieral. But I think it's just important to keep things in perspective. The journalists get their stories from interviewing professionals and doing research on things that have already have been for some time. So you just have to keep in mind that you can't simply take a reccomendation of a stock or sector that is considered undervalued. To me, if something that's very "of the moment" has been published there's a greater chance the pros have already taken advantage of it. But they are still very important to read.

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